Engineering a Venture Capital Market: Lessons from the American Experience
Gilson, Ronald J., Stanford Law Review
INTRODUCTION I. AN OVERVIEW OF THE ORGANIZATIONAL AND CONTRACTUAL STRUCTURE OF U.S. VENTURE CAPITAL II. THE ECONOMICS OF VENTURE CAPITAL CONTRACTING: THE SPECIAL PROBLEMS OF UNCERTAINTY, INFORMATION ASYMMETRY, AND AGENCY COSTS A. The Venture Capital Fund-Portfolio Company Contract 1. Staged financing 2. Control 3. Compensation 4. Exit 5. Reliance on implicit contract: The role of the reputation market. B. The Investor-Venture Capital Fund Contract 1. Control 2. Compensation 3. Mandatory distributions and fixed term C. Braiding of the Venture Capital Fund-Portfolio Company and the Investor-Venture Capital Fund Contracts 1. The braiding of exit 2. The braiding of the reputation market III. THE ENGINEERING PROBLEM A. The German "WFG" Experience B. The Israeli Yozma Program C. The Chilean CORFU Program IV. A TEMPLATE FOR GOVERNMENT ENGINEERING OF A VENTURE CAPITAL MARKET QUALIFICATIONS AND CONCLUSION
The venture capital market and firms whose creation and early stages were financed by venture capital are among the crown jewels of the American economy. Beyond representing an important engine of macroeconomic growth and job creation, these firms have been a major force in commercializing cutting-edge science, whether through their impact on existing industries as with the radical changes in pharmaceuticals catalyzed by venture-backed firms' commercialization of biotechnology, or by their role in developing entirely new industries as with the emergence of the Internet and World Wide Web. The venture capital market thus provides a unique link between finance and innovation, providing start-up and early stage firms--organizational forms particularly well-suited to innovation--with capital market access that is tailored to the special task of financing these high-risk, high-return activities. (1)
It is hardly surprising, then, that other countries have sought to emulate American success in developing an effective venture capital market. (2) At a time when developing countries are increasingly losing manufacturing jobs to low wage countries, and when low wage countries seek industries that depend on more than just cheap labor, creating a venture capital market has become the holy grail of economic development. (3)
In this Article, I seek to identify the core of the U.S. venture capital contracting model, and then assess the extent to which this model provides guidance in fashioning a venture capital market in other countries. This effort proceeds by a number of steps.
The analysis builds on what should be an uncontroversial premise--that the manner in which the U.S. venture capital market developed is not duplicable elsewhere. The U.S. venture capital market has a wildly idiosyncratic history that finds its origins in post-Gold Rush California, when Stephen Field, David Dudley Field's more successful younger brother, facilitated the adoption in California of his brother's failed New York Civil Code, and thereby planted the seeds for Silicon Valley through the Code's inexplicable prohibition of covenants not to compete. The locus then moved east, to the World War II Boston area research labs, and then west again with Frederick Terman's return to head Stanford's engineering school and his successful effort to sow the seeds of Silicon Valley by linking Stanford University and the emerging electronics industry through the creation of the Stanford Industrial Park, and then east once again with the post-World War II political decisions concerning how to finance retirement security. (4)
But while the path along which the U.S. venture capital market developed was surely idiosyncratic, the outcome of the development was not. The argument's most important step is to recognize that the keystone of the U.S. venture capital market is private ordering--the contracting structure that developed to manage the extreme uncertainty, information asymmetry, and agency costs that inevitably bedevil early-stage, high-technology financing. …